The U.S. dollar weakened on Tuesday as the Japanese yen climbed to a seven-month high, supported by growing expectations that the Bank of Japan could raise interest rates soon.
Investors also continued to unwind bearish yen carry trades ahead of important U.S. inflation data.
Yen Strengthens to Seven-Month High
The Japanese yen gained around 0.2%, briefly reaching 154.00 per dollar in early trading.
That marked its strongest level against the U.S. dollar since February.
At the same time, the U.S. Dollar Index, which measures the greenback against six major currencies, fell around 0.3% to 98.81.
The move reflected growing demand for the yen as traders reduced positions that had previously benefited from Japan’s low interest rates.
Euro and Pound Remain Relatively Stable
Major European currencies were comparatively quiet.
The euro traded near $1.1610 as investors looked ahead to the European Central Bank’s upcoming policy meeting.
Meanwhile, the British pound remained firm around $1.3520.
Currency traders appeared reluctant to take large positions ahead of several major central bank and inflation-related events.
BOJ Rate Hike Bets Rise Sharply
The main driver behind the yen rally is a major shift in expectations for Japanese monetary policy.
Stronger economic data and growing support for policy normalization have increased speculation that the Bank of Japan may raise interest rates.
Japan’s gross domestic product was revised higher on Tuesday.
The economy expanded at an annualized rate of 1.4% during the April-to-June quarter, above the preliminary estimate of 1.1%.
The stronger growth figures give Bank of Japan Governor Kazuo Ueda more support for continuing the country’s gradual move away from ultra-loose monetary policy.
Markets Price in Higher Odds of a BOJ Hike
Futures markets now indicate roughly a 75% probability that the Bank of Japan will raise interest rates by 25 basis points at its Sept. 18 meeting.
Money markets are also pricing in around a 60% chance of another rate increase before the end of the year.
Higher Japanese interest rates would reduce the yield advantage enjoyed by currencies such as the U.S. dollar.
That could make yen-funded carry trades less attractive and encourage investors to unwind existing positions.
Capital Repatriation Supports the Yen
Another factor supporting the Japanese currency is the growing flow of capital back into domestic assets.
Institutional investors have pointed to increased repatriation as interest-rate differences between Japan and Western economies begin to narrow.
This trend could provide further support for the yen if Japanese yields continue to rise.
Japanese Finance Minister Satsuki Katayama also reaffirmed that Tokyo’s currency policy remains coordinated with Washington.
She said communication with U.S. Treasury Secretary Scott Bessent remains ongoing following recent joint currency intervention operations.
Japan Uses Reserves to Support Its Currency
Official data also showed a sharp decline in Japan’s foreign securities reserves.
The country’s holdings fell by a record $87.8 billion in August as authorities used reserves to support the yen.
This highlights how aggressively policymakers have responded to excessive currency weakness.
Citi analysts said the longer-term narrowing of interest-rate differentials should continue to encourage the unwinding of yen carry trades.
If that trend accelerates, USD/JPY could face further downward pressure.
Dollar Struggles Ahead of U.S. CPI Data
The U.S. dollar has also been under pressure ahead of a key inflation report.
The greenback briefly found support after a strong U.S. nonfarm payrolls report showed that the economy added 162,000 jobs in August.
However, the Dollar Index has struggled to extend those gains.
Investors are now waiting for the next U.S. Consumer Price Index report, which could play a major role in shaping expectations for Federal Reserve policy.
Fed Rate Expectations Remain in Focus
Money markets are currently pricing in roughly a 60% probability of a 25-basis-point Federal Reserve rate increase at the Sept. 15-16 policy meeting.
However, bond and currency traders remain cautious about increasing long-dollar positions before the inflation data is released.
A stronger-than-expected CPI reading could increase expectations of further monetary tightening.
By contrast, softer inflation could reduce the case for higher U.S. interest rates and place additional pressure on the dollar.
Yen Rally Could Depend on Central Bank Policy
The next major move in USD/JPY is likely to depend heavily on the Bank of Japan, Federal Reserve and upcoming U.S. inflation data.
Rising expectations for tighter monetary policy in Japan have already strengthened the yen and encouraged investors to unwind carry trades.
At the same time, uncertainty over the Federal Reserve’s next move is limiting demand for the dollar.
If Japanese interest rates continue to rise while U.S. rate expectations soften, the narrowing policy gap could provide further support for the yen.
